Oil could put the skids under Blair

INFLATION is the long forgotten enemy of the British economy. But today, the return of rising prices - the scourge of successive Governments in the last part of the 20th century - is evident all around us.

At some service stations, petrol is changing hands at £5 a gallon, the sheer scale of the increase hidden by the subterfuge of pricing in litres.

The cost of buying a house is leaping at an astonishing annual rate - close to 20%. Most of us will face fuel surcharges on our summer holiday flights, and private sector wages, the major cost component for almost all businesses, are bubbling away at the fastest rate for three years.

As a result, the era of cheap borrowing is drawing to a rapid close. There is a belief that the best years of low inflation are behind us.

This does not necessarily mean a return to the double-digit price rises of the past, but there are ominous signs that we may all have been taking the 'end of inflation' thesis too seriously.

Certainly, central banks, including our own Bank of England, are starting to act to head off the threat. Interest rates in Britain have been raised three times since November to 4.25%, and look set to climb above 5% at the end of this year.

Economic nightmare

BORROWING costs are also heading up in the United States, Canada and Australia. And the return of high oil prices is no accident.

Many saw the war against Iraq as a chance for the West to gain control of some of the largest oil reserves in the world, but it has not turned out like that.

The triumphalism shown at the end of the war a year ago is long gone. It is now turning out to be as much an economic as a political nightmare as the growing turmoil in Iraq makes it increasingly difficult to get the oil to market.

Despite the long search for alternative sources of energy, it is Middle East oil that still fuels the factories of the world, and the Organisation of the Petroleum Exporting Countries (OPEC) has been turning the screw to increase the political pressure on the American-led coalition in Iraq.

At a time when the West and China, with its voracious growth rates, need ever larger quantities of energy to keep the wheels of industry turning, Opec chose to cut oil production in February. The result is proving catastrophic.

Oil prices have shot up 24% to $40-a-barrel, well above the target price range agreed with major Western countries.

And as evidence of the maltreatment and torture of Iraqis by coalition troops further unsettles the balance of power across the Middle East, and terrorism disrupts the oil kingdom of Saudi Arabia, the hope that oil producers will stand ready to increase output becomes ever more remote.

Over the decades, oil has proved the most potent weapon in the Arab armoury in its dealings with the West.

Opec drove oil prices to new heights at the time of the 1973 Yom Kippur war, the 1979 Iranian revolution and the First Gulf War in 1990, delivering fierce bursts of inflation to the Western democracies.

Insatiable appetite

WESTERN governments sought to pay for higher oil prices by printing more and more money, creating the conditions in which higher prices thrive. In each case it took a period of high interest rates and economic slowdown to bring inflation back under control again.

The present ballooning oil price could not come at a worse moment for the global economy. After several years of sluggish output after 9/11 and the stock market crash, the world economy is well on its way to recovery. The big drivers of this upturn are the United States, Japan and China, all countries with an insatiable appetite for oil, steel and other commodities.

Over the past ten years, China's requirement for oil has climbed by 77%. Its appetite was particularly strong in 2003, and shows no signs of easing, indeed, it is now the world's second largest oil importer behind the United States.

Beijing's awesome requirement for raw materials is not confined to oil. Chinese steel consumption has soared 25% and imports of iron ore have doubled. The impact on world prices has been immediate. The cost of some steel products has doubled.

Meanwhile, the Paris-based Organisation for Economic Co-operation and Developement (OECD) think-tank reported this week that worldwide prices of other commodities had jumped 50% from the trough of 2001. Soya bean prices are up 80% alone.

So far, the higher price for raw materials has yet to make much of an impact on the average shopping basket in Britain.

The main measure of inflation, the consumer price index, shows prices rising at just 1.1%. But this formula, introduced by Chancellor Gordon Brown last year as part of his deal with Tony Blair over the euro, provides a very partial picture.

Two of the biggest sources of inflation - the cost of housing (which takes a large slice of consumer income) and taxes - are excluded.

Bank rates policy

IN addition, the pound's strength against the dollar has insulated us from the brunt of the rise in world commodity prices - including oil - because they are priced in dollars.

But that bonus is coming to an end. The pound has started to weaken against the dollar and higher oil prices are feeding through directly to the motorist buying petrol at the pumps, the big transport firms moving goods around the country and factories burning energy. The price of the gas and coke which fuel our power stations is on the rise.

At present, the gentle rise in interest rates engineered by the Bank of England is designed to cool the housing market, send a warning on earnings and demonstrate that the authorities are serious about not letting inflation run out of control.

But the higher oil and commodity prices rise, the greater the threat to growth and employment and the more tempting it will be for the Bank to absorb the shock by allowing price increases to go on unchecked.

If the Bank holds interest rates lower than they should be, it believes it at least avoids the risk of a 1980s-style house price crash and a recession. But, more pertinently, it risks allowing inflation to rise.

The increase in energy prices could not come at a worse time in the electoral cycle. Tony Blair faces European elections and local elections shortly, and the November Presidential elections are looming into view for his diplomatic soulmate George Bush. Despite disquiet about the quagmire in Iraq, it is a long way away and elections are rarely won or lost on foreign affairs.

But oil prices hit directly at the consumers' wallet and there are already indications, on both sides of the Atlantic, of growing anxiety, even anger, among the public with demonstrations at US petrol stations and talk of protests here.

Higher oil prices threaten to be the trigger for a new era of inflation and higher interest rates. As a result, Labour's hard-won reputation for sound management of the economy could yet be shattered by the economic fallout from the Iraqi conflagration.